Stock Market Analysis
It was a volatile week for stocks but overall the S&P 500 declined 0.7% while the Russell 2000 was up 0.1%. The Volatility Index (VIX) rose from 11.5 on Friday (8/19) to 13.65 on Friday (8/26) for a 19% increase in one week. Declining stocks only modestly beat out advancing stocks, but new highs continued to swamp new lows. Usually, defensive sectors like Healthcare and Utilities hold up best in volatile markets but this time they led the declines.
The “reach for yield” is spreading to U.S. pension funds. They are employing option strategies in an attempt to increase the yields on their portfolios. In this case they are selling put options on the S&P 500 which produces income but they in turn bear the risk if stock prices fall. This process is sometimes called selling portfolio insurance because others will buy these options to protect their account from declines. The Wall Street Journal reports pension funds in Hawaii and South Carolina are now doing this with the thought this income will protect against declines in the U.S. stock market. In reality, they are essentially increasing their exposure to losses if the market falls quickly.
Typically, as long as the stock market remains unchanged or higher, the pension funds will keep the premium they receive for selling this insurance. If the stock market declines, they will have to pay those who purchased protection from them in an amount equal to the losses incurred. Generally, the bigger the stock market decline the more they would pay out.
Even more troubling, the pension funds are misunderstanding the likely effect on their portfolios. The pension funds believe this strategy will reduce risk. However, past returns show this will likely increase portfolio risk and the correlation to the stock market.
Bloomberg reports a popular equity momentum ETF has attracted more than $400 Million dollars in new assets since June 1st. While we believe relative strength is a helpful factor in stock picking, this should be paired with favorable relative valuations and profitability. As internet stock investors in the late 90’s found out, merely buying stocks with favorable price action without looking at business fundamentals eventually led to big losses. This action is a sign of excess enthusiasm.
Our leading intermediate indicators are not deteriorating significantly. Overinvested accounts could use the recent rally to trim equities, but market tops usually take considerable time. The time is coming and we are looking for candidates for sale.
Matt Watson, CFA, CPA
Bond Market Analysis
Last week the yield on the 10-Year U.S. Treasury note rose to 1.63% and U.S. Intermediate Treasuries lost 0.3%. However, the yield on the 30-Year U.S. Treasury bond remained unchanged at 2.29%. Bloomberg’s U.S. Dollar Index gained 1.12% on the week with the majority of the move coming on Friday after the FED signaled a possible rate hike is likely sooner rather than later.
The Federal Reserve meetings in Jackson Hole, Wyoming shook the bond market on Friday as investors tried to anticipate the future path of interest rates. FED Chair Janet Yellen noted an improving labor market with solid economic activity. All of this talk eventually sent the FED futures higher; especially for the month of September. Looking back at the end of July the probability of a rate hike for September was only 18%. After the speech on Friday, the probability climbed to 42%. Investors should expect an increase in volatility in the coming weeks as the September meeting nears. There are still several weeks before the September meeting and bond investors will monitor the economic releases before the meeting. A few reports to watch are from the Federal Reserve’s Regional Districts.
We like to look at their reports on new orders, as they are a good indicator of future economic activity. Recent readings from New York, Richmond and Philadelphia still indicate some weakness with two of the three negative. Readings like this, point to weaker growth in the manufacturing sectors in the comings months, which could benefit bond holders.
While the regional reports still need improvement, one broader measure of economic activity has shown some indications of turning the corner; Industrial Production. The recent readings indicate growth for the index over the past couple of months. The positive growth in back-to-back months is well overdue and has not been seen since late last summer. These two months don’t indicate a new positive trend, but may indicate the worst is possibly behind us. In addition, the energy sector will be a big determining factor on whether Industrial Production is truly getting better.
The FED over the past year has been determined to raise rates, while the economic environment and data has suggested otherwise. Going forward it will be important to monitor the frequency and velocity of the interest rates moves by the FED; as this will likely have a larger impact on bonds than occasional rate hikes. Our intermediate term indicators remain favorable at this time. We would look for opportunities to raise durations and become slightly more aggressive where appropriate.
Trent Dysert, CFA
